Saturday, July 23, 2011



A 2-Pager by Ajit Chaudhuri

Most of us, as toddlers fighting sleep (and subsequently as parents attempting to induce sleep into recalcitrant two-year-olds), have encountered the story of the three little pigs. Some of us have used the word ‘pigs’ as an adjective, usually in relation to attitudes to gender (and usually with a pejorative undertone – I humbly confess to having been an occasional recipient of this one) or to describe the behaviour of our bureaucrat-contractor-politician nexus towards the public exchequer. And now, the word has moved up in the hierarchy of the English lexicon – it has become a widely used acronym.

PIGS, for those of you who do not read the financial news, is a derogatory reference to troublesome economies in Europe – specifically Portugal, Ireland, Greece and Spain – who, by their errant behaviour, have endangered the very fundamentals of the Euro. The purpose of this paper is to understand how the PIGS have messed up, and to make sense of the rapidly increasing column inches on one or the other of this august group in the newspapers.

Let me begin with some housewife economics. If a household earns less than it spends, it has the following options –

1. Earn more

2. Spend less

3. Borrow money (and pay this back later)

4. Sell an asset

5. Get a handout from a rich relative

Option 5, on paper, seems pleasant! Unfortunately rich relatives tend to be few in number and can rarely be approached more than once, rendering this as non-tenable in the long term. Option 4, similarly, requires the existence of saleable assets and is rarely a long-term fix. Option 3 requires one to bet on future earnings being sufficient to generate a surplus (after meeting future expenditure) to pay this back – interest and all. Going wrong means drastically restructuring expenditure, losing assets, going broke, and probably committing suicide. Ultimately, it is options 1 and 2 that address the problem.

National budgets can be understood similarly, except – a government does not have the option of suicide when things go wrong. Anything more than restructuring, sale of assets and austerity measures leads to the possibility of a ‘failed state’. And a government has the following additional options –

6. It can print money, it can control the amount of money released by banks as loans, and it can set interest rates, i.e. it decides monetary policy.

7. It has some say over the value if its currency vis-à-vis other currencies. It can boost exports and spur tourism by allowing its currency to devalue (its products will be cheaper in other currency denominations). Alternatively, it can enable import-led growth by allowing its currency to appreciate.

So, what’s with the PIGS? Allow me to begin somewhat in the beginning. In 1999, a group of European countries came into a monetary union that included having a common currency, the Euro. The main advantage of a common currency is that it reduces transaction costs in trade. In the process, the members cede some control (basically those described in options 6 and 7) to a central authority – in this case the European Central Bank (ECB) in Frankfurt. Today, the Euro-zone consists of 17 members, all with different national attitudes and behavioural traits – the Teutonic Germanics, the circumspect Scandinavians, the profligate southern Europeans, the wannabe Scandinavian Baltic states, and the east Europeans who just want to be as far away from Russia as possible. The members are supposed to observe some basic rules, including that the difference between expenditure and income, also called the deficit, be 3 percent of expenditure or less (relating to options 1 and 2) and that sovereign debt (option 3) be not more than 60 percent of GDP. The members also agreed that there would be transfers to the poorer pockets within the Euro-zone (option 5) to enable them to ‘catch up’.

The first blip happened in, believe it or not, Germany. In the early 2000s, the German economy was in a sclerotic state – slow growth, high costs, and low employment. The then Chancellor sorted it out in a typically Germanic fashion; he cut taxes, made pensions and the dole less generous, and worked out a deal with the unions that held wages constant (thus enabling inflation to reduce the cost of labour over time). He also lost the next election, but the current health of the German economy is, in a large part, due to his actions.

The next blip began with the sub-prime crisis (late 2007) in the US. When Iceland fell, attention shifted from banks to the state of public finances of nations – and the PIGS were found wanting. Why the focus on PIGS? After all, they are (except Spain) not significant economies – Portugal is about the size of Malaysia, and Greece Thailand – and there are countries whose finances are in worse shape (Zimbabwe comes to mind). And the short answer is, though they are small and have different problems, each can trigger a collapse of the highly interconnected European monetary union.

Let me begin with Ireland! This country was called the ‘Celtic Tiger’ for its economic performance until 2007 and for its Anglo-Saxon attitudes. Corporate tax is low, the business environment is open, the population is skilled, and foreign direct investment poured in. The government was encouraging and circumspect, and maintained healthy public finances. Unfortunately, the Irish banks had too much money and too little oversight, and began lending to friends and relatives for dodgy projects. This was caught in the immediate aftermath of the sub-prime crisis. The Irish government now finds itself between a rock and a hard place. If it lets the banks fail, the financial system will collapse. If it rescues the banks, it would be tantamount to asking the ordinary tax payer to pay for the profligacy and bad conduct of a few (politically difficult) and would lead to the risk of moral hazard (If I know I’m going to be rescued, I will go ahead and make risky loans).

Portugal (along with Greece) should not have been a member of the Euro-zone in the first place – it is an economic backwater whose main basis for competitiveness were its low costs, which it lost by joining the Euro. Its pre-crisis growth was fuelled by option 5, handouts from the EU, and from remittances, and these did not lead to increases in either efficiency or competitiveness. I was amazed to find, in the UK, that Portuguese workers pretend to be Brazilian so that they can compete in the grey market for jobs (and therefore don’t have to be paid formal EU regulated wages), just as Brazilians pretend to be Portuguese so that they can be paid formal wages.

Greece is a complete basket case whose national attitude of ‘take them for what you can’ can only be understood if one recognises that it was ruled for centuries by Ottoman Turks and for four years, and in living memory, by Germans, and that neither rule was benevolent. It jumped on to the monetary union bandwagon by fudging its accounts, it then enabled public sector workers (the majority of its work force) to retire at 55 years with full state pensions, and it assumed that easy money (options 3 and 5) would always be available. Its economy is fundamentally uncompetitive, and its reaction to crisis (make some noises just before bail-out decisions rather than reform and restructure as per options 1, 2 and 4) has been based on its assumption of a continuing ability to threaten the larger financial system with default.

Spain is the only large (4th largest in the Euro-zone) economy among the PIGS, and therefore the one that can itself actually drag the monetary union down. Spain’s problem was that its growth and employment was centred on a single sector, real estate, which burst with the sub-prime crisis bubble.

Within Europe, the PIGS issue is seen as an outcome of south European love for siestas and Irish cronyism. Within the PIGS, there are murmurs of a north European plot to convert them into Germans and of a grand ‘destabilise the monetary union’ plan by Anglo-Saxon bond traders. Whatever the value of these assertions, everyone agrees that, as they say, ‘somethin’s gotta give.’

What can be done? The founders of the monetary union did not envisage a scenario in which a country would leave the union, but this is where the denouement of this particular Greek tragedy is heading. It will be politically difficult for northern European taxpayers to continue paying for Greece, just as it would be for Greece to undertake painful reforms to set public finances right (its current sovereign debt is at 170 percent of GDP and rising, meaning that the next two generations will have to live in austerity to pay it back). Going back to the drachma and allowing devaluation to enable competitiveness, for all its difficulties, may be the only long-term solution. For Portugal, it may be less painful to focus on reforms than to leave the union, if not for themselves than for all those banks that are heavily exposed there. Ireland needs to decide who should pay for its bad banks, the Irish taxpayer, the EU taxpayer, Ireland-based companies, or the banks themselves. Spain needs to work to broaden the base of its economy beyond housing. The EU needs to arm itself with teeth so that members adhere to the rules of membership. The ECB needs to work out ways to ring-fence troubled economies so that they do not threaten the larger financial system. And, in the long term, political union will need to follow monetary union. Simple!

1 comment:

Diti said...

Thank you. Felt like a dud this time in Cal when my friends from the Financial sector was discussing this. Poor guys, did their best to enlighten me but well...thanx once again.